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President Barack Obama will ask the Group of 20 meeting in Mexico June 18 to present “a unified message about the importance of growth,” according to Michael Froman, his deputy national security adviser for international economics. What the Obama administration means by “growth” is that Germany continue to bail out its feckless southern European neighbors. That has nothing to do with growth. The issue, rather, is who takes the hit when Europe’s illusory wealth is written off.
Europe and America both entered the 2008 economic crisis with enormous asset bubbles. America’s was concentrated in the price of residential real estate and mortgages issued against residential real estate. Europe’s is concentrated in the debt of governments and banks. America’s asset bubble has already popped, resulting in a US$6 trillion reduction in the paper wealth of American households, with a 40% reduction in the net worth of the average American family. But Europe’s institutions continue to prop up the continent’s asset bubble.
The US government misused government subsidies via Freddie Mac and Fannie Mae to promote the housing bubble, and looked the other way while financial institutions and rating agencies created a trillion-dollar house of cards in levered mortgage-backed securities. The weaker members of the eurozone used their enhanced borrowing powers to pile up daunting levels of government and bank debt.
Behind the financial manipulation in both cases was an erosion in the foundation of national wealth, as aging populations put catastrophic pressures on national pension and health systems. In the case of Europe, the number of retirees is set to double during the next 40 years while the workforce will shrink by a third.
Exhibit 1: Europe’s working age population (15-59) shrinks by a third while population over 65 doubles
Source: United Nations World Population Prospects (Constant Fertility Scenario)
Exhibit 2: America’s working population grows but retired population grows faster
Source: United Nations World Population Prospects (Constant Fertility Scenario)
In a May 2009 essay for First Things, “Demographics and Depression,” I argued that reduced family formation had shrunk America’s demand for houses and provoked the economic crisis:
America’s population has risen from 200 million to 300 million since 1970, while the total number of two-parent families with children is the same today as it was when Richard Nixon took office, at 25 million. In 1973, the United States had 36 million housing units with three or more bedrooms, not many more than the number of two-parent families with children- which means that the supply of family homes was roughly in line with the number of families. By 2005, the number of housing units with three or more bedrooms had doubled to 72 million, though America had the same number of two-parent families with children.
The housing bubble eventually had to pop, and the result was a $6 trillion write-down in American wealth. Europe’s demographic problem is far worse. Europe also requires a massive reduction in private wealth, as Nobel Prize winner from Columbia University, Edmund Phelps, explained in a January 12 op-ed in the Financial Times:
What must be done? Italy, Portugal and Greece must do without the deals that made state borrowing so cheap for them – the ill-deserved AAA ratings and the outrageous exemption of banks from capital requirements on sovereign debt holdings. Another must is a wealth tax, so that net wealth bears some resemblance to the true value of what Italians can be expected to produce, net of expected labor costs in the future. And next time an economy is in the throes of exchange rate over-valuation, it must jettison the urge to run fiscal deficits.
Some European countries, to be sure, can mitigate their demographic dearth through immigration. After the Thirty Years War of 1618-1648 wiped out most of his people, the Elector of Brandenburg, Friedrich Wilhelm I, invited French Huguenots, Poles, Jews, and others to settle in what later became Prussia. German was a minority language in Berlin during the 18th century, and might be a minority language again in the 21st century. The smartest Greeks and Spaniards may decamp for jobs in Germany.
Europe’s nominal wealth is embodied disproportionately in national debt and in the banking system, especially in the debt of the banking system. To reduce the paper value of wealth would be an overtly political act, rather than a quasi-market phenomenon as in the United States. All of Europe’s politics now revolves around the question of whose wealth gets taxed. If Spanish pensioners are told that their pensions will be reduced by a big margin because the Spanish banks made too many bad loans to construction companies while the government looked on, they rightly will blame the government. This may destroy the delicate fabric of Spanish political life. That is unfortunate, and it may be unavoidable.
There are many ways to write off the nominal wealth to levels that correspond to economic reality. The simplest and best would be for Spain, Italy and so forth simply to impose a wealth tax. But wealthy southern Europeans have been hiding their wealth for generations precisely in order to avert such an eventuality. Another way to have a de facto wealth tax is to devalue the currency, which makes everyone (but especially people of modest means) much poorer, while reducing the real liability of debtors (mainly the government). And yet another way to tax wealth is to wipe out the value of assets.
Americans accepted the overall reduction in wealth because the housing bubble was a people’s Ponzi scheme, as I wrote in this space (See The people’s Ponzi scheme, Asia Times Online, August 16, 2011). Americans speculated on their own houses, and lost. So did the Irish, who glumly accepted the consequences.
Not so the Spanish: the massive misdirection of credit to the construction sector focused on corporate rather than household lending. Financial institutions issued debt in the astonishing volume of 109% of GDP (about three times the level in the United States). The construction sector ballooned to a size large than manufacturing (vs a fifth of the manufacturing sector in Germany and a quarter in the United States).
The massive issuance of financial institutions’ securities constitutes a large portion of the wealth of Spaniards; they sit in pension funds and life insurance portfolios. Wipe out their value, and Spaniards will have to accept pension reductions. That is precisely what should be done: the banks are valueless, and their liabilities should be erased so that an external buyer can recapitalize them. The Spanish won’t like it a bit. Nor will other Europeans.
The alternative is to place a de facto wealth tax on the frugal and industrious northern Europeans, by extending Germany’s (and Holland’s) balance sheet until the euro weakens drastically, raising the cost of imported goods for the Germans. It is unfair to tax German wealth in order to maintain the wealth of the rest of Europe, and the Germans won’t like it.
In neither of these scenarios is an uncontrolled financial crisis a necessary outcome. That is a bogeyman that economists use to frighten naive and impressionable heads of state. It is entirely possible to let the Spanish banks fail, wipe all their equity and debt, and then bail out the French banks who own a great deal of the senior debt of Spanish banks. There will be no chain reaction, because the European Central Bank can simply put a circuit breaker wherever it wants.
Making a horrible example of Spain is the best alternative, in our view. Spain probably will devolve into political chaos, but the global effects will be easily contained. And Spain’s misery will persuade the Italians that fundamental reform is far preferable to repeating the Spanish experience.